Passed by Congress – the IRS only has authority to the extent they can reasonably interpret the statute

Treasury Regulations

Again, the IRS only has authority to the extent they can reasonably interpret the regulation

IRS Revenue Rulings/Revenue Proceedings

These are less binding than the previous examples – according to Evans, these are challenged fairly frequently and the odds of success are often reasonably good. (On the other hand, it takes brass cojones to challenge treasury regs, and even more to challenge the IRC)

IRS Private Letter Rulings

Also note a taxpayer can pay tax on either the calendar or fiscal year.

The Basic Tax Formula

Personal

Gross Income

- “Above the Line” deductions

Adjusted Gross Income (AGI)

- “Below the Line” deductions

Taxable Income

x Tax Rate

Tentative Tax Owed

- Tax Credits

Final Tax Due

Corporate – essentially the same, but without parts c) and d)

Tax Terminology

Income (see also infra)

Taxable Income – derived from gross income

Gross Income – defined in §61; “all income from whatever source derived.”

Any realized accretions to wealth is income

Therefore, income need not be cash; income in-kind is also taxable.

Deductions – reduce taxable income and thus provide a tax benefit; the amount of benefit increases as the taxpayer’s marginal rate increases.

“Below the Line” – Deductions taken after computing AGI; may be beneficial depending on floors, phase-outs, etc. based on AGI.

Tax Credit – a dollar-for-dollar reduction in tax. Far more beneficial than a deduction.

Fair Market Value (FMV) – the price paid between a willing buyer and seller with full information and no compulsion.

Basis – generally, an item’s cost; also, adjusted basis is the basis after taking into account factors like depreciation, etc.

Standard Deduction – in §63; inflation-indexed.

Personal Exemption – in §151; inflation-indexed.

Marginal Rates – each dollar over a given amount is taxed at a given level. Thus even a high-bracket married taxpayer’s first $36,900 of income is taxed at 15%; this is why it is a misnomer to say that moving into a higher bracket will make you worse off.

Time Value of Money (TVM) – basically, a dollar is worth more today than tomorrow. Because of this, much of a tax lawyer’s work is in deferring recognition of income and gains, while accelerating the recognition of losses.

Sales taxes are regressive because they tax consumers and don’t tax savers, and low-income people tend to be consumers while upper-income people tend to be savers.

Note the U.S. is the only country without a integrated corporate income tax, e.g., the only country that taxes dividends twice (once to the corporation as corporate earnings, then again to the taxpayer upon distribution)

Who does the incidence of this fall to? The shareholders (e.g., progressive)? Or consumers (e.g., regressive)?

Also note the problem of bracket creep; left unchecked, a taxpayer could find his income increasing due to inflation (and thus in a higher tax bracket) without any real increase in spending power. This is mitigated to a very large extent by the indexing of the rate structure, standard deduction, and personal exemption. (§§1(f), 151(f))

Criminal And Other Sanctions

Criminal Sanctions for:

Willfully failing to file or pay tax (§7203)

Attempting to evade tax (§7201)

Committing fraud on the return (§7206)

Ethics of the preparer

The taxpayer can be penalized and the attorney can be sanctioned (by both the IRS and the bar) for taking an overly aggressive tax position

“Overly aggressive” means there is no substantial authority for your position; this is interpreted to mean you have at least a 1/3 chance of winning litigation on the merits

Basically, you can’t play the “audit lottery” if you know you’d lose

The Tax Expenditure Budget

Basically, a way of publicizing the “cost” to the treasury of various deductions, credits, etc.

The idea is to make Congress just as accountable for credits as they are for expenditures

Problems include: doesn’t account for behavior changes, numbers are projections (and thus not certain), some find it offensive (because it implies that your money belongs to the government, and only by their good graces can you keep it)

Can exclude benefits from income that are so small that the hassle of accounting for them isn’t worth the trouble

Ex.: Coffee, one-time use of company car for short emergency trip

Note sports tickets and clubs are not considered de minimis

Qualified Transportation (not covered)

Qualified Moving Reimbursement Expense (not covered)

Other Excludable Fringe Benefits

§79 – Group term life insurance up to $50,000 (taxed on the excess over $50,000, if any)

§106 – Disability & Medical insurance (no limit)

§127 – Education assistance from employer up to $5,250/yr. (but not for graduate school)

§129 – Dependent Care up to $5,000/yr.

Imputed Income

This is basically “do it yourself” income – that is, the “income” you have from doing things yourself instead of hiring someone else to do it. It is not included in income.

Ex.: Owning your own home – you have “income” in the amount that you don’t have to pay rent; if you moved out and rented the house, you’d have dollar-income that would be taxable.

Policy: Primarily, it’d be impossible to assess. Plus, it would be incredibly unpopular – it’s too ‘theoretical’ for most folks.

Analysis:

This can lead to distortions in people’s choices

Ex.: The marriage penalty – it’s often cheaper for one spouse to stay at home and do housework (earning “imputed” income) than to earn money from a job.

Ex.: Distorts choice between owning and renting; absent the tax favoritism for owning (from imputed income and deductions) many would choose to rent.

Also note how this favoritism may increase the cost of housing – homebuilders are aware of the tax provisions and may increase their prices accordingly.

Windfalls

Generally, a “surprise” increase in wealth; it is taxable at the time it occurs

Ex.: You find a diamond bracelet. After turning it in to the police and waiting the requisite time, no one claims it. It is yours, and is taxable as income.

Bargain Purchases

Ex.: You buy a rare manuscript for $5

Theoretically, these could be viewed as a windfall; however, they are not. You are taxed when you later sell the manuscript. If you sell it for $10,000, you are taxed on $9,995 of income.

This only applies if the exchange was bargained-for; thus, if you buy a painting, take it home, and find an original draft of the Declaration of Independence behind the canvas it is taxable as a windfall.

Gifts & Bequests

These are not considered income for the Federal Income Tax (§102)

They are picked up by the Estate & Gift Tax, though – be careful; Evans likes to throw in questions reflecting the E&G tax and ask “is this true under the FIT?”

Also note the gift is not deductible by the donor (§262)

The substance of the transaction, and not the form, controls

When is a gift a gift?

Use the Duberstein test – look at the motive of the donor

Must be “detached & disinterested generosity” judged by “life in all it’s fullness”

This is essentially a jury issue

Basis Rules

Gift

Basis goes with the property – donee keeps donor’s basis (§1015)

However, this is subject to the “goalpost rule” (see Fig. 2)

Basically, if the gift’s FMV (when sold) is < Donor’s basis, then loss is only recognized to the extent the selling price is less than FMV.

If basis is unknown, then basis = 0

Thus, you can shift a gain to a lower tax bracket, but you can’t shift a loss to a higher tax bracket

Gift of appreciated property – if donor is in higher tax bracket, then give gift; otherwise sell and give cash

This, of course, assumes you’re getting an annuity for life; if it’s only for a specified period of time, then that time is what the payments are multiplied by to yield R

Also note that the shift to unisex tables hurts men and helps women (by accelerating women’s deductions and decelerating men’s)

Use this multiplier to determine how much of each of the annuities’ payments to exclude from income [$ x ER = Amount excludable]; [Amount taxable = $ x (1-ER)]

Note that once all costs (principal) has been recovered, all of the annuities payments are taxable as income (e.g., if you outlive your life expectancy, it’s all taxable)

Also note that if you die before recovering all of your principal, your estate can deduct the remaining principal as a loss (e.g., if you die before your life expectancy, then you get a loss)

A brief note on life insurance

Pure Term Life Insurance – no savings component; it only pays if you die; if you outlive the policy, tough luck

Whole Life Insurance – has a savings component – pays annuity on end of policy if you’re still alive

Premiums are split into insurance and savings components – only the savings component counts as basis

Note these policies are a lousy deal – the savings interest rate is low and the increased cost eats away the tax advantage. Best bet: buy term and invest the difference

Also note that payout on death is not taxed as income (§101(a)), but premiums are not deductible, either (but employer can provide some; see above)

Policy (for not taxing interest until payout): encourages savings, especially for old age (penalty for early withdrawal, e.g., prior to age 59 ½ (§72(q))

Also note that annuities are tax-favored when viewed with an amortization table – normally interest is paid early and principal is paid later. The exclusion ratio treats this as an even mix each year, and thus defers recognition of income (TVM).

See Table 2 below

Recoveries for Injuries (Damage Awards)

Business lost profits awards are taxable

But note §1033 involuntary conversion rules below

Personal Awards (see also Table 3 below)

Physical Compensatory Damages are not taxable

However, lost wages should be taxable – since physical injury awards usually have a lost income component, it is inconsistent to exclude them from gross income

Also note this may be a boon to defendants – if juries know the award isn’t taxed, the award will likely be smaller

“Physical Injury” includes emotional distress resulting from a physical injury

Structured Settlements can give both plaintiff and defendant an advantage due to the tax system – plaintiff doesn’t have to worry about being taxed on investment proceeds, and defendant generally doesn’t have to pay as much for plaintiff to get what he wants due to those tax savings.

Contingency Fees can reduce the amount included in income, but you have to show what portion of time the attorney spent working on compensatory damages, etc. (sometimes the IRS will let this be handled pro-rata)

Thus, if the tax-exempt bond pays ³ 6%, a 40% taxpayer will favor it; it will have to yield ³ 7.2% for a 28% taxpayer to favor it

Also, U.S. Treasury Bonds are excludable if used for higher education, but exclusion is phased out as income rises over $40k/single, $60k/married

The Putative Tax

A “putative tax” is paid on these investments in that you aren’t making as much as you could on a taxable investment since the interest rate is lower (and often the price is higher). This isn’t a tax in the true sense; rather, it just means you’re making less on your investment.

Depending on your tax bracket, the exclusion may or may not offset this “tax”

Arbitrage

“Riskless Profit” – using the spread between tax-free and taxable bonds to make a sure profit.

§148 prohibits arbitrage by a governmental entity – e.g., a city issuing debt to but private bonds and profiting on the difference

§265 prevents “personal” arbitrage – e.g., borrowing at a certain rate that is higher than the municipal bond’s coupon, but still profiting from the tax exclusion – by prohibiting a deduction for the interest expense on the loan

Ex.: Borrow at 8%, buy 6% municipal bonds; If you could deduct the interest on the loan (and you’re a 40% taxpayer), you would profit – you’re only paying the bank 4.8%, and thus clearing 1.2%)

The IRS uses “tracing rules” to enforce this; it is crude and easily avoided (but banks use “averaging rules”)

Transactions in Property

Realization of Gains/Losses

The Realization Doctrine – for gain to be recognized, it must be realized – i.e., there must be a change in the form of the investment (typically, a sale for cash)

Cottage Savings v. Com’r – a swap of property is “realized” if there is a material difference in the legal entitlements of the property

Thus, in Cottage Savings, a swap of loans is a taxable event (even though the loans were of the same type, they were different legal obligations on different homes – and thus different legal entitlements) (see also like-kind exchanges below)

A note on Net Operating Losses (NOL): the banks in Cottage Savings were trying to create NOL’s. An NOL is first carried back to the past 3 year’s tax returns (generating a refund, if any), and then is carried forward for 15. It would also have generated a tax loss without hurting their financial accounting income

Eisner v. Macomber – stock dividend is not income because it is not a realization of gain (the stockholder has more shares, but his financial position hasn’t changed – he still has the same percentage interest in the company, and thus no increase in wealth has occurred)

This includes the year-end increase in value in income, whether realized or not

It is used in commodities futures markets (§1256) and for securities dealer’s inventory (§457) (because valuation and liquidity concerns are lesser for these)

Many academics say this would be a better system generally, since it prevents the deferral of tax – this system is more closely aligned with the Haig-Simons theory of income than the realization doctrine

Like-Exchanges (§1031)

A like-kind exchange is not recognized as a taxable event

Policy: to permit continuation of investment

Limitations:

Property must be held for trade, business, or investment

This is looked at from the taxpayer’s point of view (the other party’s intended use of the property is irrelevant)

Must be a “continuing investment” (e.g., must be sufficiently similar)

Thus, a land-for-land swap is a like-exchange

However, a stock swap is not a like-exchange (different legal entitlements)

A swap of land for personalty is not a like-exchange (in fact, any exchange of personalty must be very similar)

RR 87-166 – Gold for silver swap is not considered similar enough (because gold is “not industrial” while silver is) (Evans thinks this is a dumb ruling that could be challenged)

Taxpayer retains his old basis; thus, if taxpayer swaps property A for property B, his basis in B is whatever his basis in A used to be

This is done to preserve gain for recognition when taxpayer sells the property

Note, however, that this is “forgiven” upon taxpayer’s death by the basis step-up rule (§1014; see also above)

Handling a mix of cash and like-kind exchange

Additional cash (or other additional consideration) is called “boot”

General rule: gain is recognized to the lesser of boot received or gain realized

Essentially, every dollar of boot given that is in excess of realized gain is recognized

You cannot use this provision more than once per 2 years (unless you are relocating to a new city)

Must be primary residence (no summer homes)

This provision is not elective

§121 One-Time Exclusion

Permits a taxpayer over 55 to exclude gain on home sale up to $125k

A one-time deal – once it’s used, that’s it (even if you don’t use the full $125k) (don’t marry someone who has used it!)

You must have lived in the old house 3 of the last 5 years

Gains are taxable (but can be deferred as per above), but losses are not deductible (because home is personal consumption)

Wash Sales (§1091)

Sale and repurchase of security within same 30-day period

Loss from such a transaction is not recognized

Installment Sales (§§453, 453A, 453B)

Provides relief from having to pay tax on accrual when payments are received in installments by allocating a portion of each payment to gain and a portion to basis recovery (and a portion for interest)

The installment method is elective – you can pay tax up front if you wish (but why would you?) (§453(d)) (Installment method is the default)

Ex.: If above sales’ first year payment is $60k, then $40k of gain is recognized

§453(e) prevents loophole of using relatives (e.g., selling by installment to lower-bracket relative, then having them sell for full price)

Installment method cannot be used for:

Personal property on a revolving credit plan (§453(k)(1))

Sales of publicly traded property (§453(k)(2))

Sales of inventory items (§453(b)(2))

Time/share residential lots (not a total prohibition, but must pay interest on all tax deferred) (§453(l))

Interest is also owed on deferral if sales price is greater than $150k

Publicly traded debt instruments and demand notes (because they are the functional equivalent of cash) (§453(f))

Depreciation recapture (also, recapture is taxed as ordinary income to prevent tax arbitrage)

Contingent installment payments can be handled by (TR §15a.453-1(c))

If you can determine a maximum amount to be paid, that amount is considered the selling price

If you can’t do the above, but can figure a maximum length of time, then basis is allocated evenly over that time period

If you can’t do either of the above, allocate basis evenly over 15 years

Original Issue Discount (OID) and Market Discount

Imputes an interest rate when either there is none or when the stated rate is not a true reflection of interest (e.g., zero-coupon bonds, and bonds issued at a discount)

It applies to any debt instrument, however – bonds, debenture, note, certificate, or other evidence of indebtedness (§1275(a)(1)(a))

§467 also makes OID rules applicable to deferred rent payments (for these, take PV of payment at 1.1 (110%) of the applicable rate)

Note a tax-exempt bond’s discount is taxable

Tax treatment

Each year, look at Net Present Value (NPV) of bond; the increase is taxable as income (not capital gain)

NPV = par value/(1+ rate)#years to maturity

Gross income year 1 = NPV1 - NPV0

Gross income year 2 = NPV2 - NPV1, etc.

See Table 4 below

If bond with coupons is sold at a discount, must tax both OID income and interest income from coupon payments

If bond is given for property (instead of cash), the interest payments must meet the applicable federal rate (§1274(d)); the property is considered to be sold for the present value of the bond’s face amount

Basis and early disposition

Discount/ # years to maturity = accrued market discount per year

Ex.: 5-year $1,000 bond sold for $800; $200/5 = $40/year

The discount amount accrued is ordinary income when bond is sold; any excess is capital gain. This prevents taking the preferred CG rate by selling the bond shortly before maturity.

Ex.: Same as above. 3 years after purchase, sell bond for $920 (gain = $920 - $800 = $120); $40 x 3 = $120; all of the gain is ordinary income

This is not the same thing as OID; it is discount after original issue caused by market conditions (interest ­, price ¯, and vice versa)

Market discount is fully deferred until maturity

Ex.: A buys 20-year bond at par ($1,000); 5 years later he sells it for $800

Seller – gets a $200 capital loss

Buyer – recognizes coupon payments as income each year, but does not recognize the $200 in income until maturity (a total deferral of discount)

Note if OID bond is sold, the OID must be recognized as income by the buyer

Taxation of the Family

Marriage

Brief history of joint returns

Lucas v. Earle – held that husband could not shift his income to his wife to take advantage of marginal rates

Poe v. Seaborn – community property state; court says that since husband and wife each own ½ of income, the income should be split between husband and wife

Congress permits joint returns to prevent favoring community property states over other states; effect is that for a married couple, it doesn’t matter who earns the income

The Marriage Penalty and Marriage Subsidy

Penalty – when two high-wage earners marry, one spouse’s income is taxed at a higher marginal rate than it would be if they were single

Subsidy – If there is only one wage earner in a family (or one is a very low-wage earner), there is a marriage subsidy since the wage earner is taxed at a much more favorable rate than if he/she were single

It is impossible for a tax system to have progressive rates, joint returns, and neutrality toward marriage. One of the first two would have to go to eliminate the penalty/subsidy

Divorce

Some payments are taxable (§71(a)) to payee and deductible (§215) to payor

Taxable/Deductible

Alimony

Maintenance

Not taxable/deductible

Child Support

Property Settlements (§1041 – no tax on transfers between spouses, even as an incident to divorce)

The basic rationale is that the nontaxable expenditures are those that would have to be made even if the couple had stayed married (child care) or is just a division of what is already owned (property)

Note alimony is an “Above The Line” deduction

Therefore, there is an incentive to make payments alimony – if payor is in high tax bracket, and payee is in lower tax bracket, payor gets valuable deductions while payee gets cash that is taxed at her lower rate

Difference between rates x amount = tax savings

(40% - 15%) x $140 = $35

Say both parties want settlement to be $100

Payor gets $16 savings: $140 - 40% = $84; $100 - $84 = $16 savings

Payee gets $19 bonus: $140 - 15% = $119; $119 - $100 = $19 bonus

$16 + $19 = $35 total tax savings

You can elect to treat alimony as a nondeductible/nontaxable property settlement, but not vice-versa

Requirements to classify a payment as alimony (§71):

Must be paid in cash (no in-kind transactions)

Must be an instrument of divorce or other maintenance (no oral agreements and no single people)

Note that separation is OK too (“other maintenance”)

Parties must not have agreed that it won’t be taxable/deductible

Can’t be member of same household (must actually split up)

Can’t have payments after death of payee (usually wife); have to break out alimony portion from property settlement portion

Can’t be for child support

Can’t cease upon child reaching a certain age, marrying, dying, etc.

If the payments cease within 6 months of the child reaching the age of majority, then it is presumed to be child support

Must be roughly equal payments for the first 3 years (e.g., no property settlements)

The payments are recaptured if the first or second year payments are more than $15,000 than subsequent year’s payments

Note that even if deductions are recaptured, you still have gotten a TVM advantage from the delay

The Kiddie Tax (§1(g))

Child under age 14’s unearned income is taxed at the parent’s marginal rate

Tax is levied on the excess of $500 (plus either expenses or $500 of the standard deduction)

Only applies to unearned income – paper routes, etc. are taxable to the child at his own rate. This only applies to interest, dividends, etc.

Policy

Age is < 14 because presumably once child is 14 the parents may be saving for college

Not concerned with earned income because there is little chance for fraud

Basically is designed to prevent parents from shifting income to their children (who are in lower tax brackets)

Rises up until income reaches $8,425, then plateaus until income is at $11,000, then is phased out to zero at an income level of $27,000

Operates as a percentage of earned income; more kids means a higher percentage (up to two); Most you can “make” is $3,370

The credit is 40% of earned income until the “peak”, then after the plateau it is phased out at 21.06% of earned income over $11,000

Policy: makes transfer payments less demeaning; encourages work

Problems: fraud, adds to marriage penalty

Personal Deductions

Personal Exemption (§151)

You get a personal exemption for yourself and one for each dependent

Dependency requirements (§152):

Related by blood, marriage, or adoption (or certain special cases in §152(a)(9))

Taxpayer must provide over half support (giving scholarships is not included)

The dependent must have income less than the exemption amount

The personal exemption is phased out at higher income levels

It is reduced by 2% for every $2,500 of AGI over the threshold amount ($100k for singles, $150k for married people)

The $2,500 layers are not pro-rata – if you’re in the layer, you lose the full 2%

Standard Deduction (§63)

The standard deduction varies with the status of the taxpayer (married, single, etc.)

The amount of the deduction is adjusted each year for CPI

There is no phaseout for the standard deduction

Itemized Deductions (§68)

These are “below the line” deductions, and thus less valuable because of caps, threshold amounts, etc., than a “above the line” deduction

The total of all allowable itemized deductions are reduced by the lesser of:

3% of AGI over a certain amount (which is indexed for inflation – base amount is $100k in 1991 dollars)

80% of allowable deductions

For phaseout purposes, this only applies to home mortgage interest, property taxes, charitable contributions, and §212 investment expenses; medical expenses, casualty losses, etc., are not included in the computation

Note this is designed to phase out itemized deductions at higher income levels; thus it “secretly” increases taxes on the wealthy to above the statutory rate

Casualty Losses (§165(c)(3))

Permits a deduction resulting from “fire, storm, shipwreck” or other casualty

Generally, the loss must be similar to the specifically mentioned ones, i.e., the loss must occur with suddenness

Ex.: Dyer – spastic cat knocks over vase; court says it’s not a casualty loss since it’s not similar enough to the listed casualties

The loss is measured as the lesser of FMV and Basis

Limitation on casualty loss deduction (§165(h))

First, reduce the loss by $100

Then, reduce that number by 10% of AGI

Note this has the effect of increasing the tax on marginal AGI to above the statutory rate

Policy: Expenses are involuntary, reduced ability to pay, unforeseen

Extraordinary Medical Expenses (§213)

Medical expenses are deductible for any amount in excess of 7.5% of AGI

Note this is inconsistent, since medical benefits paid by employer are not taxable as income (§105(b), §106)

Congress partially addressed this by permitting a 30% deduction of health insurance premiums for self-employed people (increasing to 80% by 2006) (§162(1))

Also, recovery under medical insurance is not income even if it exceeds medical costs; if employer provides, he can deduct without employee recognizing income (§106, §162)

What is a medical expense?

Medical insurance premiums are considered medical expenses and are deductible

This is inconsistent, since fire/homeowner’s insurance isn’t deductible as a casualty loss

Basically, there must be a “direct and proximate” relationship between the expense and the disease

Thus, a general recommendation is not considered treatment (e.g., if doctor says “exercise,” you can’t deduct a pool – but if doc says “swim,” deduction may be permissible)

OCHS – Sick mom can’t deduct boarding school for the kids as a medical expense

Taylor – Doc tells patient not to mow lawn; paying for lawn service is not a medical expense

You can only deduct for you, your spouse, and dependents (i.e., no pets)

Policy: Expenses are involuntary, reduced ability to pay, unforeseen

Charitable Contributions (§170)

You may deduct contributions to certain charities (e.g., no bums). The types of charities permitted are listed in §170(c)

Deduction makes it cheaper to give; ex.: 40% taxpayer donating $100 only actually gives $60; the rest is “paid” by the government

The contribution cannot be a quid pro quo – the motive must be “pure”

Thus, in Ottawa Silica a company donating land for a school cannot deduct the donation, since the school’s presence would increase the surrounding land’s value for development

Investment company would have to capitalize the cost of donated land to the value of the remaining land

For personal contributions, the value of the benefit received offsets the value of the deduction (thus, a charity dinner for $100/plate where food was worth $30 yields a $70 deduction)

Also, de minimis quid pro quo is permissible (like Joe Jamail having the library area named after him in exchange for big contribution)

Donations of property

Deduction is valued at property’s FMV - donor’s basis

Note then that you can making a donation of appreciated property is cheaper than cash – you avoid the gain, and the charity generally doesn’t pay tax if it sells the property

For this to apply, the property must have been held by the donor for more than one year (e.g., must be long-term capital gain property)

Note this treatment is anomalous – if you gave property in payment of services, you would be taxed as though you sold it

The property cannot be inventory – it must be investment property

Limitations on charitable deductions

The deduction is limited to 50% of contribution base (generally AGI) for donations to churches, educational organizations, medical institutions, and certain publicly supported organizations and charities (e.g., the Red Cross)

It is limited to 30% of their cost, and that is reduced if it exceeds 20% of AGI for contributions to other organizations (e.g., private foundations)

Additional Notes on Charitable Contributions

If property given is > $5,000, must have value appraised

Must document if donation is > $250 (more than a canceled check)

Note that self-interest is always better served by not giving; the deduction only makes it cheaper to give – it doesn’t make it a superior financial move compared to selling property for gain or investing

You cannot deduct the value of services given

The charity deduction is considered very tax-efficient

Interest

Business

Generally, interest is deductible for use in trade or business

It is permissible to finance recievables

When financing construction, the interest incurred while the building is being erected is added to the basis of the building; however, once complete the interest is deductible in full as an expense each year (because then the building is generating income)

The business deduction is taken “above the line”

Investment

Investment interest is deductible “below the line” (because the interest is being used to generate income)

The deduction is limited to net investment income

This equals all gain income from all portfolio investments

Evans: this is where realization screws up the system – appreciated stocks, etc., aren’t counted toward the offset even though there has been an economic gain

The deduction is carried forward indefinitely until it’s all used up

If you want to include long-term capital gains in net investment income, it is taxed at ordinary income rates (it is elective, and the default is to not include it

This is to prevent arbitrage (see tax-exempt bonds above) that would result from deducting at ordinary rate but recognizing gain at preferential rate

If you expect to have ordinary gain in the next several years, it’s better to exclude LTCG; otherwise, include it

This is not all-or-nothing – you can elect to recognize a portion of LTCG at the ordinary rate

Generally, education is not deductible unless it maintains your skills in a current trade or business

TR §1.162-5 establishes test:

No deduction if:

Completing minimum requirements for new job, or

Study which could lead to a new trade or business (this is why law school is not deductible)

Deductions are permitted if:

It maintains skills needed for a trade or business, or

Thus, CLE is OK, as is a LLM (if you’ve practiced for awhile)

Is an express requirement of employer or law as a condition of employment

If deductible, it is a non-reimbursed business expense deductible “below the line” subject to the 2% floor

Policy for not allowing deduction of college costs

Indeterminate Life (why not use life expectancy?)

Intractable mix of personal and business expenditure

“Intellectual Capital” is deferred

Job Search Costs (note how it’s inconsistent with moving expenses)

Entry-Level – not deductible

New Field – capitalized over life (Sharon)

New Job in Same Field – current deduction (like repair expenses)

Pure Business Expenditures

Capitalization and Repairs

Capitalization – adding a cost to basis and depreciating it; not deducting it immediately

You are supposed to capitalize anything that extends an asset’s useful life beyond the end of the taxable year

§263 UNICAP rules – require that any self-created asset be capitalized, and that both direct and indirect costs (e.g., salaries and overhead) of producing the asset by included in the capitalized amount

Thus, GM must include the cost of supervisor salaries in its basis for cars (basically, basis thus means Cost of Goods Sold)

GM doesn’t like this because this means the cost of supervisor salaries cannot be deducted currently; instead, the costs are capitalized in their year-end inventory and the cost is not recovered until the car is sold

This is mostly because of difficulty in determining a useful life – if a campaign is successful, it may last many years; if not, it may only last a month or so

Also, the media lobby strongly opposes capitalizing these costs

Research & Development Costs (§174)

These should clearly be capitalized – R&D is always a long-term asset, virtually by definition

Capitalization isn’t required since permitting a current deduction encourages research – something Congress wishes to do. Also, useful life is difficult to figure

Intangible Drilling Costs (§§263(c), 263A(c)(3))

Most of the costs of preparing to drill an oil well are immediately deductible (see also below in ‘depletion’)

Why? Oil and gas lobby is powerful – also, oil is important to national security (so says the lobby)

Timber Costs

The costs of raising trees is immediately deductible

Why? Again, politics (e.g., Sen. Packwood’s from Oregon)

Raising Livestock

Cost of raising a cow is deductible, even though the cow is clearly a long-term asset

Why? That’s right, politics. (Evans jokes “farmers never have to pay taxes”). The “family farm” image of unsophisticated people working the land is an effective political tool (never mind that most farming these days are done by agribusiness). Farmers are damn well-organized

Environmental Remediation (RR 94-38)

Cost of returning land to unpolluted state is immediately deductible

This is because it presumably isn’t an improvement – it’s considered merely returning the land to its prior condition

Evans: this has been a hot area for about the past five years; when is something remediation and when is it an improvement? (ex.: asbestos replacement isn’t remediation)

Repairs vs. Improvements

A repair is immediately deductible; an improvement must be capitalized

A repair is something that mends and asset and does not add to the asset’s value or prolong its life

Improvements are just the opposite – they add to the value or improve its life

This fits with Haig-Simons income – a repair doesn’t increase wealth; it just maintains the status quo

There is no precise dividing line between which is which; it’s all judge-made, and the decisions are all over the board

Rule of Thumb – the larger the expenditure is in relation to the asset’s value, the more likely its not a repair

This typically is an issue with closely held corporations, who attempt to disguise dividend payments as salary.

The IRS looks at a lot of factors to determine reasonableness; Evans says this rarely comes up and he knows of many small corporations that pay large salaries to their principal stockholders with no problems

Note this issue does not arise with partnerships or S corporations, since these entities don’t pay tax directly (the partners are taxed on earnings)

§162(m) prohibits a widely-held corporation from deducting more than $1M per year for the salary of its CEO or next four highest paid employees

This is done because of the controversy over salaries of guys like Mike Eisner

There is an exception for performance-based salary (that is tied to income generation)

§§280G, 4999 restrict deductions for golden parachutes

Illegal Activities

There is a line of cases (Sullivan, Tank Truck, Tellier) that developed varying times when expenses could be deducted for illegal activities

Finally, the IRS decided that any business deduction would be permissible for illegal enterprises if there was not a statutory exception in the code.

Evans: however, many courts will still deny such deductions for public policy reasons anyway; typically they do so under §165, which ostensibly isn’t controlled by §162

Nondeductible items for illegal activities (§162)

Cannot deduct fines paid to a government for violation of the law

Policy: shouldn’t reduce the ‘sting’ of a fine, since that is the purpose of the fine in the first place

Court-ordered restitution is not a fine, however; thus, Exxon was able to deduct the cost of the Valdez cleanup in Alaska

Cannot deduct bribes and kickbacks to government officials, officials of foreign governments, or private individuals (if private bribery is illegal in the state in question)

For foreign governments, it is illegal if it violates the Foreign Corrupt Practices Act

Under that act, “grease” is legal – if the bribe is to “speed up” bureaucracy (and not to influence opinion), then a deduction permissible

This is so because in many countries “grease” is considered a part of the official’s compensation (like tipping)

Side note: §901 permits a credit for income taxes paid to other countries, but not if they aren’t recognized or are terrorist-supporting countries

As for bribing private individuals – it is only not deductible if against state law and the law is enforced

Double Declining Balance (DDB) – Take whatever straight line would be; figure what percentage that is of cost; deduct double that percentage from basis each year (e.g., if SL = 20% of original cost, take 40% off current basis each year); Switch to SL when it becomes more favorable

This method is used for 3-10 year personal property

150% Declining Balance (150DB) – same as DDB, but percentage used is 150% of SL percentage (instead of 200%)

This method is used for 15 and 20 year personal property

Depletion (§613)

An mining or oil company can deduct a percentage of gross income each year for depletion (varying from 22% to 5%; 15% for oil) in an amount not to exceed 50% of taxable income

This can be used forever, even in excess of cost

Also, oil companies can deduct intangible drilling costs immediately (instead of capitalizing; see above); this includes the preparatory work for finding a site and building a rig (but not the rig itself)

The Alternative Minimum Tax (AMT)

The AMT is imposed on individuals to prevent them from ducking all tax liability; it is reached by taking taxable income, adding back certain preferences, and applying a lower rate

The rate is 26% on the first $175k, 28% on the rest; for corporations, it is 20%

Preferences added back:

Business

Depreciation (taken with longer depreciable life)

Tax-exempt interest

Percentage depletion in excess of cost

Intangible drilling costs (excess over 10 yr. amount, to the extent it is in excess of 65% of oil & gas income)

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